Macroeconomics Eighth Edition, Global Edition Chapter 4 Financial Markets Ⅰ • Copyright © 2021 Pearson Education Ltd. Chapter 4 Outline Financial Markets I 4.1 The Demand for Money 4.2 Determining the Interest Rate: Ⅰ 4.3 Determining the Interest Rate: Ⅱ 4.4 The Liquidity Trap Copyright © 2021 Pearson Education Ltd. Financial Markets • Financial markets are intimidating, but they play an essential role in the economy. • In this chapter, we focus on the role of the central bank in affecting these interest rates. • We learn how the interest rate on bonds is determined, and the role of the central bank (Federal Reserve Bank, or the Fed, in the United States) in this determination. Copyright © 2021 Pearson Education Ltd. 4-1 The Demand for Money • Suppose you only have a choice between two assets: money and bonds. • Money are used for transactions, but it pays no interest. • Two types of money: currency and checkable deposits. • Bonds pay a positive interest rate, i (the rate of interest), but cannot be used for transaction. Copyright © 2021 Pearson Education Ltd. 4-1 The Demand for Money • The holding of money and bonds depends on: – Your level of transactions $Y – The interest rate on bonds i • You can hold bonds indirectly through money market funds, or money market mutual funds. • In the early 1980s, the interest rate on money market funds reached 14% per year, so people earned more interest by moving their wealth from checking accounts to these funds. Copyright © 2021 Pearson Education Ltd. Money market mutual fund • Open end mutual fund vs. Closed end • An open end mutual fund (tradition): A type of mutual fund that does not have restrictions on the amount of shares the fund will issue. If demand is high enough, the fund will continue to issue shares no matter how many investors there are. Open-end funds also buy back shares when investors wish to sell. • A closed-end fund (new), CEF, is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange. • Money market mutual funds are open-end mutual funds • ETF (not CEF) : exchange-traded funds (daily trade) https://www.fidelity.com/learning-center/investmentproducts/closed-end-funds/cefs-mutual-funds-etfs • Copyright © 2021 Pearson Education Ltd. FOCUS: Semantic Traps: Money, Income, and Wealth • Money is what can be used to pay for transactions. • Income is what you earn, and it is a flow. • Saving is the part of after-tax income that you do not spend, and it is also a flow. • Savings is the value of what you have accumulated over time. Stock variable • Financial wealth, or wealth, is the value of all your financial assets minus all your financial liabilities, and it is a stock variable • Investment is what economists refer to as the purchase of new capital goods. • Financial investment is the purchase of shares or other financial assets. Copyright © 2021 Pearson Education Ltd. 4-1 The Demand for Money • Demand for money (Md) is equal to nominal income $Y (a measure of level of transactions in the economy) times a decreasing function of the interest rate i: What is the interest rate? Functions of money Medium of exchange Unit of account Store of value • Money is the most liquid asset in the world • An increase in the interest rate decreases the demand for money, as people put more of their wealth into bonds. Copyright © 2021 Pearson Education Ltd. 4.1 The Demand for Money (4 of 5) • Equation (4.1) means that the demand for money: – increases in proportion to nominal income, and – depends negatively on the interest rate. • The relation between the demand for money and interest rate for a given level of income $Y is represented by the Md curve. Copyright © 2021 Pearson Education Ltd. 4-1 The Demand for Money Figure 4-1 The Demand for Money For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right. Copyright © 2021 Pearson Education Ltd. FOCUS: Who Holds U.S. Currency • The amount of currency in circulation in 2006 was $750 billion. • U.S. households together held $170 billion in currency. • U.S. firms held another $80 billion. • Foreigners abroad held $500 billion, or 66% of the total, for transactions, especially in countries suffering from high inflation in the past. Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I • Suppose the central bank decides to supply an amount of money equal to M: Ms = M • Equilibrium in financial markets requires that Ms=Md=M Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I Figure 4-2 The Determination of the Interest Rate The interest rate must be such that the supply of money (which is independent of the interest rate) is equal to the demand for money (which does depend on the interest rate). Copyright © 2021 Pearson Education Ltd. Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I Figure 4-3 The Effects of an Increase in Nominal Income on the Interest Rate Given the money supply, an increase in nominal income leads to an increase in the interest rate. Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I Figure 4-4 The Effects of an Increase in the Money Supply on the Interest Rate An increase in the supply of money leads to a decrease in the interest rate. Copyright © 2021 Pearson Education Ltd. 4.2 Determining the Interest Rate: Ⅰ (5 of 9) • For a given money supply, an increase in nominal income leads to an increase in the interest rate. • An increase in the supply of money by the central bank leads to a decrease in the interest rate. Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I • Central banks typically change the supply of money by buying or selling bonds in the bond market—open market operations. • Expansionary open market operation: the central bank expands the supply of money by buying bonds. • Contractionary open market operation: the central bank contracts the supply of money by selling bonds. – Treasury bills are issued for terms of less than a year. – Treasury notes are issued for terms of two, three, five, seven, and 10 years. – Treasury bonds are issued for terms of 30 years. Copyright © 2021 Pearson Education Ltd. 4.2 Determining the Interest Rate: Ⅰ (7 of 9) Figure 4.5 The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount. Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I • Suppose a bond such as a Treasury bill, or T-bill, promises to pay $100 a year from now. • If the price of the bond today is $PB, then the interest rate on the bond is: $100 − $𝑃𝐵 𝑖= $𝑃𝐵 • The higher the price of the bond, the lower the interest rate. • The higher the interest rate, the lower the price today. • Discount bonds Copyright © 2021 Pearson Education Ltd. 4-2 Determining the Interest Rate: I Rather than the money supply, the central bank could have chosen the interest rate and then adjusted the money supply so as to achieve the interest rate it had chosen. Choosing the interest rate, instead of the money supply, is what modern central banks, including the Fed, typically do. Taylor Rule Copyright © 2021 Pearson Education Ltd. 4-3 Determining the Interest Rate: II • Financial intermediaries: Institutions that receive funds from people and firms and use these funds to buy financial assets or to make loans to other people and firms. • Banks are financial intermediaries that have money, in the form of checkable deposits, as their liabilities. • Banks keep as reserves some of the funds they receive. • The liabilities of the central bank are the money it has issued, called central bank money. Copyright © 2021 Pearson Education Ltd. 4.3 Determining the Interest Rate: Ⅱ (2 of 6) Figure 4.6 The Balance Sheet of Banks, and the Balance Sheet of the Central Bank Revisited Copyright © 2021 Pearson Education Ltd. 4-3 Determining the Interest Rate: II Assume people hold no currency so the demand for money by people is the demand for checkable deposits: • The demand for reserves by banks depends on the amount of checkable deposits: • θ is the reserve ratio, and Hd is demand for high-power money or the monetary base. Copyright © 2021 Pearson Education Ltd. 4-3 Determining the Interest Rate: II • Let H denote the supply of central bank money, then the equilibrium condition: • Or using equation (4.4): • An increase in H leads to a decrease in the interest rate, and a decrease in H leads to an increase in the interest rate. • monetary base (also base money, money base, highpowered money, reserve money, outside money, central bank money). • Outside money is money that is not a liability for anyone "inside" the economy. Copyright © 2021 Pearson Education Ltd. 4-3 Determining the Interest Rate: II Figure 4-7 Equilibrium in the Market for Central Bank Money and the Determination of the Interest Rate The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money. Copyright © 2021 Pearson Education Ltd. 4.3 Determining the Interest Rate: Ⅱ (6 of 6) • The federal funds market is an actual market for bank reserves. • The federal funds rate is the interest rate determined in the federal funds market. • The federal funds rate is the main indicator of U.S. monetary policy because the Fed can choose the federal funds rate it wants by changing H. Copyright © 2021 Pearson Education Ltd. FOCUS: Will Bitcoins Replace Dollars? • Bitcoins are virtual assets that can be used for transactions. • As of December 2018 the total value of bitcoin in circulation was $67 billion. • Bitcoins are not likely to replace dollars for 3 reasons: 1. Most transactions are quoted in dollars, so price risk exists. 2. Verifying bitcoin transactions takes too much electricity. 3. Governments do not want bitcoin to be the accepted currency since they want to control monetary policy. Copyright © 2021 Pearson Education Ltd. Copyright © 2021 Pearson Education Ltd. 4.4 The Liquidity Trap (1 of 2) • Zero lower bound: The interest rate cannot go below zero. • The economy is in a liquidity trap when the interest rate is down to zero, monetary policy cannot decrease it further. Copyright © 2021 Pearson Education Ltd. 4.4 The Liquidity Trap (2 of 2) Figure 4.8 Money Demand, Money Supply, and the Liquidity Trap When the interest rate is equal to zero, and once people have enough money for transaction purposes, they become indifferent between holding money and holding bonds. The demand for money becomes horizontal. This implies that, when the interest rate is equal to zero, further increases in the money supply have no effect on the interest rate, which remains equal to zero. Copyright © 2021 Pearson Education Ltd. Tools of Monetary Policy Tools of Traditional Monetary Policy Open market operation Discount rate Reserve requirement New Monetary policy tools under Ample Reserves Framework Interest on Reserves Overnight reverse repurchase agreement (ON RRP) rate https://www.stlouisfed.org/open-vault/2020/august/how-doesfed-influence-interest-rates-using-new-tools • FFR is higher than IOR Copyright © 2021 Pearson Education Ltd. Before The Crisis Federal Funds Market Fed purchases of U.S. government securities would increase the supply of reserves in the banking system, thereby shifting the supply curve to the right and moving the federal funds rate (FFR) lower. In contrast, sales of securities would reduce the supply of reserves, thereby shifting the supply curve to the left and moving the FFR higher. Copyright © 2021 Pearson Education Ltd. New Monetary policy Tools under Ample Reserves Framework FFR should be close to IOR • Banks can deposit it into their reserve account at the Fed and earn interest on reserves (IOR). Because IOR offers banks a risk-free option, it serves as a reservation rate — the lowest rate a lender is willing to accept when lending funds. • If IOR>FFR, banks could borrow at the FFR and deposit the reserves at the Fed (earning the IOR rate) to earn a profit. • This arbitrage activity should ensure that the FFR won’t fall very far below the IOR rate and links the rates together. • Because the IOR rate is an administered rate, the Fed can nudge the level of the market-determined federal funds rate by adjusting the setting of interest on reserves. In the ample reserves framework, IOR is now the primary tool the Fed uses to adjust the FFR. Copyright © 2021 Pearson Education Ltd. New Monetary policy Tools under Ample Reserves Framework FFR should NOT be lower than ON RRP rate • Not every financial institution that operates in the federal funds market has access to interest on reserves. So, the FFR could fall below the setting of the IOR rate. • To aid in the control of the level of the FFR, the Fed introduced the overnight reverse repurchase agreement (ON RRP) facility to a broad set of financial institutions. • When an institution uses the ON RRP facility, it essentially deposits reserves at the Fed overnight, receiving a government security as collateral. The next day the transaction is “unwound” — the Fed buys back the security, and the institution earns the ON RRP rate on the cash it deposited at the Fed. Copyright © 2021 Pearson Education Ltd. New Monetary policy Tools under Ample Reserves Framework FFR should NOT be lower than ON RRP rate • Because this (ON RRP rate) is a risk-free investment option, the institutions will likely never be willing to lend funds in any market for lower than the ON RRP rate. And, if similar short-term rates fell too far below the ON RRP rate, institutions would borrow at those lower rates and deposit this cash at the ON RRP facility to earn the ON RRP rate. • These forces link the ON RRP rate to other short-term rates, including the FFR. Because many large nonbank financial institutions have access to the Fed’s ON RRP facility and the ON RRP rate is set below the IOR rate, the ON RRP rate serves as a supplementary policy tool and acts like a floor for the FFR. Copyright © 2021 Pearson Education Ltd. After (under Ample Reserves system) The Fed no longer uses daily open market operations to adjust the federal funds rate. Copyright © 2021 Pearson Education Ltd. FOCUS: The Liquidity Trap in Action • The large increase in the supply of central bank money between 2008 and 2015 was absorbed by households and banks. • Uncertainty in economic outlook would cause households to increase bank deposit and would prompt bank to increase their reserve holdings. Figure 1 Checkable Deposits and Bank Reserves, 2005−2018 (billions). Source: FRED: TCP, WRESBAL Copyright © 2021 Pearson Education Ltd. Case of USA Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits • Assume that overall money demand is: • Also assume that people hold a fixed proportion of their money in currency c, and (1−c) in checkable deposits, so the demand for currency and the demand for checkable deposits are respectively: Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits Figure 4-A1 Determinants of the Demand and the Supply of Central Bank Money. Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits • Let R be the reserves of banks, D be the dollar amount checkable deposits, and θ be the reserve ratio: • Combining (4.A2) and (4.A4) gives the demand for reserves by banks: Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits • Demand for central bank money is: so that: which gives the demand for central bank money: Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits • The equilibrium condition is that the supply of central bank money be equal to the demand for central bank money: or using equation (4.9): Copyright © 2021 Pearson Education Ltd. APPENDIX 1: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits • The supply of central bank money (the left side of equation (4.A9) is equal to the demand for central bank money (the right side of equation (4.A9), which is equal to the term in brackets times the overall demand for money. Fractional Reserve System Copyright © 2021 Pearson Education Ltd. Appendix 2: Monetary base, Money multiplier From eq. (4.A9), we have 1 𝐻 = $𝑌 𝐿(𝑖) 𝑐+ 1−𝑐 𝜃 The LHS is the total money supply and the RHS is total money demand. The supply of total money is equal to central bank money/high power money H (or monetary base) times money multiplier (1/[c+(1-c)]). Monetary base=currency + reserve Money multiplier is greater than one. Copyright © 2021 Pearson Education Ltd. High power money(Monetary Base) Copyright © 2021 Pearson Education Ltd. Money multiplier Copyright © 2021 Pearson Education Ltd. What is the eventual increase in the money supply? The increase in checkable deposits is $100 when seller 1 deposits the proceeds of his sale of bonds in bank A, plus $90 when seller 2 deposits the proceeds of her sale of bonds in bank B, plus $81 when seller 3 does the same, and so on. Copyright © 2021 Pearson Education Ltd. The series in parentheses is a geometric series so its sum is equal to Copyright © 2021 Pearson Education Ltd. Definition of money • 我國中央銀行採用的貨幣定義如下: M1A = 通貨淨額 + 支票存款 + 活期存款 M1B = M1A + 活期儲蓄存款(個人或非營利法人) M2 = M1B + 定期存款 + 定期儲蓄存款 + 外匯存款+ 郵政儲 金 + 附買回交易餘額 + 外國人新台幣存款 + 貨幣市場共同基 金 – --準貨幣 (Quasi money) • 美國: M1= currency + checkable deposits Copyright © 2021 Pearson Education Ltd.